What are interest rates, and why do they matter in trading?

Interest rates are the cost of borrowing money or the return on investment for lending money. They are typically expressed as a percentage and are used in various financial transactions and instruments, including loans, savings accounts, bonds, and mortgages. 

Why are interest rates important? 

Interest rates play a crucial role in the economy as they influence consumer spending, business investment, and overall economic growth. Central banks, such as the Federal Reserve in the United States, often set short-term interest rates as a tool to manage monetary policy and control inflation. When interest rates are low, borrowing becomes cheaper, stimulating spending and investment. Conversely, higher interest rates can help curb inflation and slow economic growth.

Beyond their macroeconomic implications, interest rates play a significant role in shaping trading activities across various financial markets. The relationship between interest rates and trading can be complex, but here are some ways in which interest rates can affect trading.

How do interest rates affect trading?  

1. ‍Borrowing costs: Interest rates directly influence borrowing costs for traders and investors. When interest rates are low, it becomes cheaper to borrow money, which can encourage traders to leverage their positions and engage in more speculative trading strategies. On the other hand, high-interest rates can increase the cost of borrowing, potentially leading to reduced trading activity.
2. ‍Cost of capital: Companies often depend on debt financing, and the cost of debt is closely tied to prevailing interest rates. When interest rates are low, companies might be more inclined to invest in growth and expansion using debt financing. For publicly listed companies, this boost in development can increase investor confidence, which could potentially lead to increased trading volumes in their stocks. 
3. ‍Equity valuations: How investors value equities are influenced by interest rates. Lower rates can make stocks and other equities relatively more attractive compared to fixed-income investments like bonds. As a result, investors might be more willing to invest in the stock market, potentially leading to higher trading volumes and upward pressure on stock prices.
4. ‍Forex markets and currency exchange rates: Interest rates are also a key driver of currency values. Higher interest rates tend to attract foreign investors seeking higher returns. This increased demand for the domestic currency can lead to an appreciation of the currency's value relative to other currencies. Traders in the forex market usually will closely monitor interest rate differentials between countries to make trading decisions. 
5. ‍Bond market: When interest rates rise, existing bonds with lower coupon rates become less attractive to investors because new bonds are issued with higher coupon rates. This can lead to a decrease in demand for existing bonds and potentially result in bond price declines, prompting changes in trading behaviour within the bond market.
6. ‍Commodities and futures: Lower interest rates can decrease the cost of holding and storing commodities as well as increase the attractiveness for investors seeking higher returns. This can lead to higher demand for commodities and commodity-related assets, which may drive up their prices. 
7. ‍Investor sentiment: Changes in interest rates can influence investor sentiment and risk appetite. When interest rates are low, investors may seek higher returns by venturing into higher-risk and higher-return assets like stocks. This can include engaging in more aggressive trading strategies, potentially increasing the trading volume and volatility across different asset classes, which would affect the price movements of the assets. Conversely, rising interest rates can lead to a more cautious approach. 
8. ‍Options and derivatives: Interest rates impact the pricing of options and other derivatives, influencing trading decisions for those engaged in options trading. For example, an increase in the risk-free interest rate will lead to higher discounting, which results in a decrease in the present value of the option's potential future value. This decrease tends to lower the calculated option price. Conversely, a decrease in the risk-free interest rate will lead to lower discounting and an increase in the calculated option price.
9. ‍Real estate and housing: Interest rates also play a crucial role in the real estate industry, which will impact the prices of stocks related to real estate. Lower interest rates can make mortgages more affordable, stimulating demand for homes with potential returns from real estate investments might seem more attractive compared to other lower-yielding options. When the real estate industry is perceived as strong and thriving, investor confidence in related companies (property management, construction, home builders) can increase, leading to higher stock prices.

Importance of interest rates

In summary, interest rates have far-reaching effects on trading activities across various financial markets. Traders and investors closely monitor changes in interest rates as they can impact the cost of capital, borrowing costs, investor sentiment, asset valuations, and the attractiveness of different investment options.

Keep an eye on the markets when central banks make decisions relating to interest rates, and take advantage of the price movements when these decisions are made with a Deriv account.